Lagerquist Accounting Blog
Read the latest blog articles from Lagerquist Accounting and Advisory.
Subscribe for Blog Updates
Recent Blog Articles
How an Outsourced CFO Can Help You Establish Accounting Practices To Minimize Risk and Maximize Profit
An outsourced CFO can provide your small business with the accounting services and financial management advice you need to successfully navigate from your break-even point, so you can maximize profits and boost ROI.Read more
Leveraging the Expertise of an Accounting and Advisory Firm to Support and Optimize Your Accounting System
This fourth article in our series outlines the benefits of partnering with an external advisory firm in optimizing your business finances. We look at the comprehensive services offered by outsourced accounting specialists and how they can support your in-house teams and processes toward ideal results throughout the work year. Bookkeeping is an essential aspect of […]Read more
Lagerquist’s third part of an in-depth blog series explores how partnering with a reliable external accounting and advisory firm can help your company avoid five of the biggest pitfalls faced by businesses. External accounting specialists provide extensive real-world experience that help companies navigate the most significant financial challenges with minimal guesswork.Read more
Striking the Balance: Utilization vs. Realization in Professional Services Firms
Posted by Sylvia Lagerquist, CPA
Two of the most important metrics to monitor in any professional services firm are utilization and realization. When your business sells the time and resource capacity of your people, the ability to measure the effectiveness and profitability of those people as billable resources is of paramount importance.
In summary, utilization represents the amount of hours a given billable resource (i.e. person) bills vs. the amount of hours that resource works. Realization represents the actual revenue billed against the utilization, so it takes into account not just the time but the value of that time to the business financially.
Note: For a review of key concepts and a more in-depth discussion of the terms relating to this topic, see our previous article, Understanding Utilization, Realization and Profitability in Your Professional Services Firm.
Depending upon the industry being served, a professional services firm will generally expect anywhere between 65% and 85% utilization out of a typical billable employee. The remaining time would then be spent in non-billable activities such as business development, continuing education, professional activities, holidays/paid time off and administration.
The reason that a balance between utilization and realization is important to strike, is that if either one becomes imbalanced against the other, it can indicate the presence of serious inefficiencies or problems in your estimating, operations or employee capacity to execute on the tasks assigned.
Exploring a Real-Life Example
Let’s look at an example to help uncover the relationship between these two concepts in a real-life scenario. For this example, let’s discuss a fictional employee named John Doe.
John Doe works for ABC Consulting, and in that position he is a salaried employee with an effective hourly pay rate (at 40 hours per week) of $30 per hour. When overhead, insurance, benefits and other compensation costs are taken into account, John’s ‘loaded’ cost is $50 per hour to the company.
John is assigned to a project with multiple tasks, and one of his assigned tasks is to develop the plan for the next phase of the project. ABC Consulting included 100 hours in the project budget for this task, estimated at an hourly rate of $150 per hour. Therefore, the budget for this task is $15,000 and the gross profit margin for this task is $10,000. In addition, John is given one calendar month to complete the task and still make the project deadline.
In order to meet that budget, John has to complete the work in 100 hours (or less), and the cost of the time involved should not exceed John’s own cost to the company (i.e. if another, more senior employee had to step in for part of the work, the budget would be broken even if the work was completed in the assigned 100 hours). In addition, it has to be completed in the timeframe assigned, otherwise either the work will be late or additional resources will have to be brought in to finish on time.
Understanding Key Factors and Targets
We need to make sure the following factors are in alignment in order for these targets to be achieved:
First, we need to know that John will have 100 hours available during the assigned calendar month, after we subtract the time he needs for other billable work during the same period, and after we subtract the time during which he is not billable. If John is typically reaching a 70% utilization rate, then that means John has an average of 28 hours per week available for billable work, or 112 hours for the calendar month.
This work has been assigned at 100 hours, so that means we are only leaving 12 hours for work overruns or for other billable tasks during the month. Of course, it is possible for John to work additional time without added cost (assuming his salary exceeds the federal overtime threshold), but we don’t want to routinely expect employees to work overtime and corrode employee loyalty or longevity either.
Second, we need to be confident that 100 hours is enough time for the work to get done — and enough time for John to do the work. Is it reasonable and do we have enough history in prior projects to demonstrate that 100 hours is the right timeframe for this task, and that a resource with John’s level of experience, expertise and capacity to execute can consistently complete the work in that timeframe?
Third, we must ensure that John can do the work alone, and that we’re not ignoring the need for higher-cost resources to be involved. If we need to bring in a third-party consultant for just 20 hours of work on this task at $125 per hour, and John reduces his time on the task down accordingly (from 100 to 80 hours in total), then we’ve cut our gross margin from $10,000 down to only $8,500. Here’s how:
John Doe: 80 hours at $50 per hour = $4,000
Consultant: 20 hours at $100 per hour = $2,500
Total Labor Cost – $6,500
Gross Profit Margin – $8,500
This represents a greater than 10% loss of profit to the company just on that one project task. If this becomes the case across the project as a whole, and the original plan was to achieve a 67% margin, then this could cut the firm’s profitability on the project dramatically. And of course, if John still consumes his full assignment of 100 hours on the task while we’ve also added the third-party consultant, we could set a trend that turns a profitable project into a net loss for the company.
What is essential to understand here is the factors that are critical to achieving our balance between utilization and realization effectively:
1. Accurate estimating of project work tasks
2. Accurate assignment of work tasks to employee resources
3. Accurate employee costing
4. Accurate pricing of employees as billable resources
5. Educated assessment of employee time availability for tasks associated with new and pending projects
6. Effective project management and employee supervision before and during projects
7. Dedicated professional development of billable employees to improve their efficiency and precision
In looking at this list, what’s significant is that only two of the seven items involve the employee himself or herself. The other five tasks involve the company’s other functions — estimating, costing, project management and management of client and prospect expectations.
The Role of the Employee
Many professional service firm leaders mistakenly assume that since utilization and realization are metrics focused on how employees spend their time, this means that any problems with these metrics automatically involve the employees themselves. In fact, most mismatches or imbalances that we can uncover with these two metrics have to do with the other areas of the process, and not directly with employees.
Of course, we do want to address employee issues when appropriate. Every billable professional services employee needs to know that how they plan their time, what they do with their time, and how quickly or efficiently they work when they are on billable time, are all fundamental responsibilities they must attend to.
Nonetheless, the smart professional services firm executive recognizes that systems, processes, procedures and metrics are the keys to managing the team toward profit — and only after those are in place and working smoothly do we turn our attention to the employee factor first.
By monitoring and managing utilization and realization on each project, task and team — and by instilling a culture and set of best practices so that supervisors engage proactively with their employees on these considerations — you will set your professional services firm on a positive course toward sustainable growth for the long term.
Image Credit: Mark Lord Photography | Image Source: Flickr @ Creative Commons
Lagerquist Accounting Blog
Welcome to the Lagerquist Accounting & Advisory Blog.